These class notes and supplemental materials are written by an investor who audited Joel Greenblatt’s Special Situation Class at Columbia’s Graduate Business Program from 2002 through 2006. Different years may have an overlap of material and concepts covered by the prior year’s notes but the repetition and
supplemental material may improve retention. Any errors, omissions or faulty premises are the notetaker’s fault and not implied or committed by the speakers or persons presented. Please use these notes as a spur to your own efforts and thinking in how to become a more effective investor. I hope this help. Comments welcome at [email protected]
Greenblatt Class #1
Sept. 07, 2005
A Story Selling Gum
My goal is to teach you the course that I never had and that I wish I had. I started in business school 25 years ago. What I know about investing other than reading financial statements, I learned on my own
reading and making mistakes. Hopefully, I can give you the benefit of my experience.
A number of years ago I was trying to explain to my son what I did for a living. He is 11 years old. I spoke about selling gum. Jason, a boy in my son’s class, sold gum each day at school. He would buy a pack of gum for 25 cents and he would sell sticks of gum for 25 cents each. He sells 4 packs a day, 5 days a week, 36 weeks or about $4,000 a year. What if Jason offered to sell you half the business today? What would you pay?
My son replied, “Well, he may only sell three packs a day so he would make $3000 a year. Would you pay $1,500 now? Why would I do that if I have to wait several years for the $1,500?
Would you pay a $1? Yes, of course! But not $1,500. I would pay $450 now to collect $1,500 over the next few years, which would be fair. Now, you understand what I do for a living, I told my son.
I sit around trying to figure out what businesses are worth, and then I try to pay a lot less for them. I
think you get the point. The Skills I Will Teach You
I really don’t think the skills that I am going to teach you are very valuable. It is not that you can’t make a lot of money from what I am going to teach you. There are fundamentally better things you can do with your time. My view is that the social value of investing in the stock market as being similar to being good at handicapping horses. There is a benefit to having markets for raising capital; they just really don’t need you. I think what I am going to teach you this semester is really how to make money and so whatever social benefits there are to society, it is not very large. So if you do end up following my advice and it works for you, I would ask that you find some way to give back. I am one iteration removed so what I am doing? I truly wish that I had the chance to have this course to help out in some way.
Divergence between Prices and Values:
Prices fluctuate more than values—so therein lies opportunity.
Why are prices of each company so variable and volatile compared to the value of companies?
If I take out the newspaper and I pick out any large cap stock like IBM, Cisco, EBay, KKD, Google, why are the prices all over the place? Look at the wide divergence between the 52 week high/low. Here is a business that hasn’t changed much but the price has gone from $35 to $70. $7 to $30 and right now to $20. Look at ANF and INTL.
Questions:
These are all pretty good companies and this has been the least volatile period in many years, and there have been 100% moves over one to two year periods—why the huge disparity?
Are markets efficient?
Why do MBAs and other smart people not do well in money management? People invest with their emotions. They process information differently.
Does it make sense that these prices fluctuate so much while the values of the underlying companies do not move around in a short period of time? (Price diverges from value).
Joel Greenblatt (JG): It is very clear—pick any company you want--the price is very volatile over short
periods of time. It does not make sense to me that the values are nearly as volatile as the prices and therein lies what should be a great opportunity. All these companies which have fairly established businesses (Disney, Boeing, Wal-Mart) the values are not fluctuating nearly as widely as the prices. There should be great opportunity, yet there are not many winners in the market.
The reason why that is…….in the final analysis……why do the price fluctuate so widely when values can’t possibly? I will tell you the answer I have come up with: The answer is I don’t know and I don’t care. We could waste a lot of time about psychology but it always happens and it continues to happen.
I don’t know and I don’t care. I just want to take advantage of it. We could sit there and figure it all out, but
I like to keep it simple. It happens; it continues to happen; the opportunities are there. I don’t know why it
happens and I don’t care—I just want to take advantage of prices away from value.
In this course, I am going to teach you how to take advantage of that. I will make a guarantee now: If you do good valuation work and you are right, Mr. Market will pay you back. In the short term, one to two years, the market is inefficient. But in the long-term, the market has to get it right—it will pay you back in two to three years. Keep that in mind when you do your analysis. You don’t have to look at the next quarter, the next six months, if you do good valuation work—and we will describe what that means—what the best metrics to use, Mr. Market will pay you. In the long-term Mr. Market eventually gets it right; he is very rational. That is very powerful. That is the context in which you should think this semester.
The big picture:
There are lots of smart guys on Wall Street yet most of them go out and basically fail for many reasons—they are unable to contribute value. I have a firm, Gotham Capital; we have averaged 40% per year for 20 years. $1,000 would now be $836,683. There are lots of smarter people who can do better spread sheets than I can; there are lots of smarter analysts than me. I think the difference to how we have been able to do it is that we
think simply and a little bit differently.
The context in which we put our analysis—not that our analysis is any better than anybody
else’s. We are not experts in any particular industry, we are not smarter than anybody else,
and we are not doing better analysis. The fact that you are here means you can do the
analysis. It is the context in which you put that analysis that makes the difference to
you.
Simplify, place valuation into context, practice.
That should be encouraging to you that you don’t have to be smart, or have to do a million hours of work or tricky analysis, but you have to be good. You have to know what you know—Your Circle of Competence. You don’t have to be the best in the world at figuring stuff out. It is the context which I will teach you those
simple things and then we will do a lot of practicing--practice of doing valuation while keeping the simple context in mind. Even I have to remind myself to remember what is important. You must be able to cut through all the noise. The Wall Street Journal has more info in it in one day than the entire world had 700 years ago.
How to Beat the Market
Many people don’t beat the market, so name some ways that you can do it.
Focus on small caps where the markets are more inefficient. There is less analyst coverage so less information flow. You have the chance to find prices more above or below value. Small caps have more opportunity to
find mis-priced stocks.
Small Caps: Another secret, when money managers learn their valuation work and focus on small caps, they make a lot of money, and they graduate from small caps. For a guy starting out there is always an
opportunity to do original work. There is turnover in the ranks.
Activist Investing: JG won a proxy fight and eventually made money but it was not worth the pain. His first and last foray into activist investing.
Special situations: A corollary to small cap investing. You go where other people aren’t. A more inefficient area of the market. Value investing with a catalyst.
Student: Superior knowledge in an industry. Linda Greenblatt focuses in retail.
Concentrate your investments.
How Gotham generated great returns:
Gotham Capital stayed small. We returned outside capital, so we could invest in as many situations as possible (not constrained by size). We are very concentrated. We invest in 5 to 8 securities. Know your
companies very well. Why that is more safe than diversifying? You pick your spots. So if your holding
period is three to five years and you only have 4 to 6 securities, then you only need one or two ideas a year. That is why I have time to teach this class. It is more fun and it works.
Why Value Investing Works
Richard Pzena:
1960-2005 S&P 500 Value Benchmark: Low P/E, Low P/Sales Difference
Returns 11% 16.3% 5.3
1995 – 2000
Returns 163% 71% -91%
Note the LT outperformance of Value Metrics but the 5 year or more periods of underper-formance. Value Investing works because it doesn’t work all the time
Value investing works, but it tends to work in cycles. Pzena lost 70% of his investors. Now of the $14 billion he manages he only has 4 (Joel G. is one of them) of his original investors.
Joel G: I was down 5% in 1998-1999 but worried about a bubble breaking in 1999 (a macro worry), but I
could find cheap companies—look how cheap Brk.a got in 1999. They kept doing what they were doing. He was up 130% in 2000. The markets came back.
Read: What Works on Wall Street by James P O’Shaughnessy. He started a fund in 1996-1997 but he underperformed the market by 25% and after three years in business of underperforming he sold his company at the bottom of the cycle. The guy who wrote the book quit his system! It seems like it is easy to do, but it is not easy to do.
This book, What Works on Wall Street, has born out its wisdom. The two funds that are patented that fool his strategy have been phenomenal. HFCGX is the patented fund based on his top idea of Cornerstone Growth; over the last 5 years it has had an average return of 13.44% per year vs. the Vanguard 500's -2.01% per year (6/1/00 through 5/31/05). HFCVX is the patented fund based on his 2nd to best idea of Cornerstone Value; over the last 5 years it has had an average return of 6.47% per year vs. the Vanguard 500's -2.01% per year (6/1/00 through 5/31/05).
The most interesting point is that the author points out those investors often are to emotionally involved to have the discipline to see the strategy through. Not only did the first reviewer bash the book because he did
like the returns strategy one year after the book came out, but Mr. O'Shaughnessy sold the funds to Hennessy Funds at the end of 1999 after it failed to surpass the returns of the bubble that soon after collapsed. Seven years after it was published an investor would be much wealthier had they followed the
books top strategy instead of the investors who dog-piled onto the stocks of the market's bubble.
We are going to try to understand why it works. Why it has to work over time. That is the only way you can stick it out.
The math never changes: 2 + 2 = 4. That is the level of your understanding I want you to have by the time we are done. If I get that right, forget all this other stuff and noise, I will get my money. No genius required.
Concepts will make you great.
There is a lot of experience involved in valuation work, but it doesn’t take a genius or high IQ points to know the basic concepts. The basic concepts are what will make you the money in the long run. We are all capable of doing the valuation work.
Overview of the course.
His book, How You Can Be a Stock Market Genius was written for the general public but he learned that it was written more at an MBA level.
Brian Gains was one of our analysts at Gotham. He will be one of the speakers in this class. The Value Investor’s Club:
Six years ago, we found one of our best investments that was trading at ½ cash value and it had a very good business attached. We found it because of the very complicated capital structure. We thought we were the only ones to find it. We found another person on Yahoo.com who had analyzed the situation correctly. Hey, there is intelligent life out there. Get together these smart people and share ideas.
If you get A+ in this class you could get in.
This is the application procedure. You have to know certain metrics that Yahoo members don’t know. I am not vouching for any write-up in particular. Read the reviews above 5.7 with many reviewers. You can search by rating or person. Usually 5.5 and above is pretty good. You can look at example after example and see what happened years later. You see smart investors asking questions. There is a lot to choose from here. It is a great learning tool. A great research archive to build an investment thesis. I can’t recommend this highly enough. Do not share your ID for the VIC with anyone. This is a great learning resource for you. You can search by investor and see what makes for a good write-up. We have found a number of superior investors. A simple and clear thesis.
Review
• Stocks bounce around a lot.
• The market closes the gap.
• We seek a margin of safety.
Valuation:
What are the different Valuation Methodologies?
DCF: Discounted Cash Flow (problems) you have to make projections. The terminal value can change
drastically due to small changes in assumptions. What earnings does the price imply? What growth rate and what discount rate am I using to get to that valuation three years from now? What would justify that future price? I sort of work backwards and throw in a bunch of numbers like growth rate. What is this price I am expecting it to be worth imply? I use it as a reality check to decide and see if my assumptions can be justified. What it tends to do is force me to use conservative numbers.
How do you know if you are conservative?
What if you can’t figure this out—like growth rate or discount rate? Pass on it. If it is hard for me to figure it out, I go onto the next one.
Relative value: look at similar businesses and what they are trading at. Problems: the businesses are not really
similar. It might be tough to find a good comparable. Everything might be overvalued in a sector, so you are comparing one overvalued asset with another. Comparables might be over or under valued.
Replicating value—I don’t usually do that. The communists made square wheels because they cost the same
to make as round wheels.
Break-up value: A company has two divisions one is making $3 and the other is losing $1 (EPS = $3 - $1 =
$2). The stock trades at $34 so PE = $34/$2 = 17x but if you close down the bad business, it really trades at 11 times or $34/$3.
Where the stock has traded in the past is noise. What is it worth? Where is it today (Price).
Acquisition value: You have a discount brokerage account with 100,000 accounts that acquires Brown Co’s
50,000 customers, so they can pay more that company due to just adding customers to thei5r infrastructure. The acquisition value might be much higher than the DCF value.
I don’t like to see values per subscriber or x hospital beds. I still want to see the cash flows translated from the hospital beds. I don’t like to see relative value.
Summary: Valuing a Company
We have four ways to value a company: 1. DCF or intrinsic value, 2. Relative value, 3. Break-up value, and 4. Acquisition value
Balance Sheets, Income Statements and Cash Flow Statements A company trades at $6 per share and it has $5 per share in cash.
Current Assets: (CA) First we look at CASH. We have often found companies are trading at close to its cash per share. Technology stocks in 2002. $5 per share in cash and
You can value the $5 in the company’s pocket but it is not in your pocket. What will the company do with that cash? How will they redeploy the cash?
Will they dissipate the cash or use it wisely like returning it to shareholders? Look at management and decide if they are capital destroyers. How is their bread buttered, do they own a lot of stock or are they paid mostly in salaries.
Look at where the business is—is it earning money, is it earning $ in other businesses? Is management doing good things with the money? If management is doing good things, I may put full value on that cash. Or I won’t take it at face value if the business is losing money. Make sure it is net cash.
They may need more working capital so I may have to haircut the cash figure. I usually give a discount to the cash on the balance sheet. Generally capitalism works. Are these guys’ losers. People running a business are generally more entrepreneurial. Are these guys treating it like their own money or somebody else’s money? There always nuances. If I am not sure, I will put a very conservative value on the cash to take care of that uncertainty. You may say you know what; this $5 should only be worth $3. Do I still want to buy the company with what is left?
That $5 really is worth $3.00. Something as simple as cash on the balance sheet, there are many iterations of how do I look at cash? A lot of people just look and accept the cash value, but I analyze it. I will value that $5 at $4 or $3. Usually this won’t keep me from investing; I will just put a big discount on it (the cash). Probably when the company makes a big acquisition that is the time to sell.
Accounts Receivables:
What are the considerations there? Does the receivable number make sense? If A/R is rising quickly, then they are pumping out sales and extending credit—that may be good, it may be bad.
Inventories:
There are ways to look at that. Current Assets, prepaid assets.
WC: Accounts Payable, short term portion of long-term debt.
Assets: PP&E, Real Estate (how much have those assets appreciated).
Intangibles: goodwill—the excess paid for assets above the book value of those assets.
A little secret: Operating profit. Usually I use a 40% tax rate. The number I like to use is operating profit—a pre-tax number so comparisons are easier.
D&A are not cash expenses. Now you don’t amortize goodwill unless you write it off.
EBITDA—don’t show this in your reports. You have to subtract out the maintenance capital expenditures (MCX). Now, if the company is growing and you want to figure out “normalized earnings.” Capital spending is the number to use. Capex is a cash expense but depreciation is a book entry not cash.
Let us say you are opening 10 new stores in addition the 10 stores you already have, the capex would include keeping up the ten stores you already have making capex on those stores and the cost of opening the ten (10) new stores but you won’t get the benefit of those new stores in that year. For normalized earnings what you really want for normalized earnings is maintenance capex. How is this number reported? Ask the
management. Break out growth vs. maint. Capex.
I ask for an explanation for mcx and how do they get there. Usually the company understates mcx. When EBITDA, DA = capex, then EBIT = EBITDA – Capex. A quick and dirty when you use EBIT. I try to get at EBITDA – maint. Capex.
The Cable Industry is in a continual upgrade cycle.
Look at EV/Sales, EBIT/EV. EV/EBIT is pre-tax earnings yield. Why you use Enterprise Value (EV)?
COMPANY A
$10 EBIT 40% tax rate $6 in Net Income P/E 10
$60 million Market Cap. or EV = $60
COMPANY B
$10 EBIT
-$5 Interest Expense
=$5 million in pre-tax operating $3 mil. in int. expenses.
$15 mil in market cap + $50 mil in debt = $65 in EV
A is cheaper with a PE of 10 while Company B has a P/E of 5. The price of the EV is lower for A at $60 vs. $65 for B.
I look at EV to sales not P/S. The point of this exercise is that when you show me your comparables and you say the average P/E--every analyst report shows the industry ratios where they say the industry is trading at 13x and this company is trading at 12x so it is cheap--it doesn’t take into account market capitalizations, differences in tax rates and things of that nature. And looking at things through an EV/EBIT basis does. To make apples to apples comparison we will use EBIT/EV.
The Importance of ROIC vs. ROE
Do I care about the ROE? I care about the return on capital (ROIC).
The first thing I look at ROIC = EBIT/ (NWC + Net Equipment). How good a business is this?
Pre-tax return/Net Tangible Capital. What capital the company needs to use to be in business--NWC + Equipt. Net Working Capital (NWC): Use financial A/R and eliminate the excess cash. Subtract Accounts Payable NIB debt.
Why eliminate goodwill? Because it states historical costs. It doesn’t matter what I paid. You want to know going forward what type of business you are looking at.
EBIT/EV Earnings yield. What price am I paying relative to earnings? Avoid value traps (low return businesses).
Hotel Capex:
Spend $1,000 for a hotel. Then spend $25 per year for MCX, but then in year 5, I need to refurbish the hotel for $400 to stay competitive. So I would add ($400/5 or $80 per year to the $25 per year and deduct $105 per year in true maint. capex).
$25 Capex +$80 Capex =$105 Capex $25 Capex $80 Capex =$105 Capex $25 Capex $80 Capex =$105 Capex $25 Capex $80 Capex =$105 Capex $25 Capex $80 Capex =$105 Capex
$400 in fifth year so apportion $80 mil. per year over regular MCX
Summary of What Joel teaches in the Little Book That Beats the Market
You will learn:
• How to view the stock market.
• Why success eludes almost all individual and professional investors.
• How to find good companies at bargain prices.
• How you can beat the market all by yourself.
The key is to understand the simple concepts in this book
Most academics and professionals can’t help you to beat the market. YOU must do it yourself.
You have to believe that the story is true. Most professional investors have learned wrong and very few people believe or else there would be many more successful investors. They aren’t.
Compare Our investment alternatives
We want to compare how much we can earn from a safe bet like a U.S. government bond with our other long-term investment choices. We want to make sure we earn a lot more from our other investments than we could earn without taking any risk.
Buying a share in a business
Buying a share in a business means you are purchasing a portion (or percentage interest) of that business. You are then entitled to a portion of that business’s future earnings.
• We have to estimate what the business will earn in the future.
• How confident are we in our prediction?
• Nest year is only one year. What about all the years after that? Will earnings keep growing every year?
• The earnings from your share of the profits must give you more money than you would receive by placing that same amount of money in a risk free 10-year U.S. government bond.
Figuring What A Business Is Really Worth?
Why do the prices of all these businesses move around so much each year if the values of their businesses can’t possibly change that much?
Why are people willing to buy and sell shares of most companies at wildly different prices over very short periods of time? I just have to know that they do!
Who knows and who cares? Maybe people just go nuts a lot.
Ben Graham figured out that always using the margin of safety principle when deciding to purchase shares of a business from a crazy partner like Mr. Market was the secret to making safe and reliable investment profits.
Valuation
How are you supposed to know what a business is worth? If you can’t place a fair value on a company, then you can’t divide that number by the number of shares that exist, and you can’t figure out what the fair value of a share of stock is.
In the process of figuring out the value of a business, all you do is make a bunch of guesses and estimates. Those estimates involve predicting earnings for a business for many years into the future. Even experts (whatever that means) have a tough time doing that.
Learning the Concepts
You must make a willing suspension of disbelief.
It is hard to predict the future. If we can’t predict the future earnings of a business, then it is hard to place a value on that business.
If you just stick to buying good companies—ones that have a high return on capital—and to buying those companies only at bargain prices—at prices that give you a high earnings yield—you end up systematically buying many of the good companies that crazy Mr. Market has decided to literally give away.
Buying good businesses at bargain prices is the secret to making money. Graham’s Formula:
His formula involved purchasing companies whose stock prices were so low that the purchase price was actually lower than the proceeds that would be received from simply shutting down the business and selling off the company’s assets in a fire sale. He called these stocks by various names: bargain issues, net-current-asset stocks, or stocks selling below liquidation value).
Graham stated that it seems “ridiculously simple to say that if one could buy a group of 20 or 30 companies that were cheap enoughto meet the strict requirements of his formula, without doing any further analysis, the “results should be quite satisfactory.” In fact Graham used this formula with much success for over 30 years. Graham showed that a simple system for finding obviously cheap stocks could lead to safe and consistently good investment returns. Graham suggested that by buying a group of these bargain stocks, investors could safely earn a high return without worrying about a few bad purchases and without doing complicated analysis of individual stocks.
Magic Formula Results
Over the seventeen years, owning a portfolio of approximately 30 stocks that had the best combination of a high return on capitaland a high earnings yield could have returned 30.8 percent per year. $11,000 would have turned into $1 million before taxes and transaction costs.
To make the Magic Formula Work:
It will be your belief in the overwhelming logic of the magic formula that will make the formula work for you in the long run.
How the Formula Works:
The formula looks for the best combination of those two factors out of a 3,500 company database. Getting excellent rankings in both categories (though not top ranked in either) would be better under this ranking system than being the top-ranked in one category with only a pretty good ranking in the other.
No Size Effect
The Magic Formula Results for the top largest 1,000 companies: 22.9% vs. 12.4% for the S&P 500 over 17 years. The formula works for companies large and small.
The Magic Formula seems to work in order of Deciles. There should always be plenty of highly ranked stocks to choose from
How does the Magic Formula fare vs. the market?
The formula fared poorly 5 out of every 12 months tested. Annually the formula failed to beat the market once every four years.
If the magic formula worked all the time, everyone would use it. If everyone used it, it would probably stop working. The formula doesn’t work all the time.
For the magic formula to work for you, you must believe that it will work and maintain a long-term investment horizon.
Timeless Principles
In order for the magic formula to make us money in the long run, the principles behind itr must appear not only sensible and logical, but timeless. Otherwise, there is no way we will be able to “hang on” when our short-term results turn against us.
We are buying on average above-average companies that we can on average buy at below-average prices. The opportunity to invest profits at high rates of return is very valuable because it can contribute to a very high rate of earnings growth!
To earn a high return on capital even for one year, it’s likely that, at least temporarily, there’s something special about that company’s business. Otherwise, competition would already have driven down returns on capital to lower levels.
In short, companies that achieve a high return on capital are likely to have a special advantage of some kind. That special advantage keeps competitors from destroying the ability to earn above-average profits. So by eliminating companies that earn ordinary or poor ROC, the magic formula starts with a group of companies that have a high ROC.
Then the mf will buy only those companies that earn a lot compared to what we are paying. Why the mf works?
A good track record only helps once you understand why the track record is so good.
The mf beat the market averages 95% of the time (160 out of 169 three-year periods tested)! The worst return was a gain of 11% vs. a loss of 46% for the market averages.
There are two things you want to know about an investment strategy: What is the risk of losing money following that strategy over the long term?
What is the risk that your chosen strategy will perform worse than alternative strategies over the long term? If an investment strategy truly makes sense, the longer your time horizon you maintain, the better your chances for success. Time horizons of 5, 110 or 20 years are ideal.
Over the long run, Mr. Market gets it right.
I guarantee that if you do a good job valuing a company, Mr. Market will eventually agree with them. Two or three years is usually all the time they’ll have to wait for Mr. Market. To reward their bargain purchases with a fair price. Over time, facts and reality take over. Smart investors search for bargains, companies buy back their own shares, and the takeover or possibility of a takeover of an entire company—work together to move share prices toward fair value.
Choosing Companies on Your Own
Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you are still an idiot.
The mf looks at last year’s earnings. But the value of a company comes from how much money it will earn for us in the future, not from what happened in the past.
Ideally, we should be plugging in estimates for earnings in a normal year.
"If you took our top fifteen decisions out, we'd have a pretty average record. It wasn't hyperactivity, but a hell of a lot of patience. You stuck to your principles and when opportunities came along, you pounced on them with vigor."
- Charlie Munger, Vice Chairman, Berkshire Hathaway
--Greenblatt Class #2
Sept. 14, 2005
Some definitions of Free Cash Flow = EBIT – Maintenance Capital Expenditures (MCX) – annual changes in working capital. Changes in annual working capital (WC) are due to working capital changes needed for growth.
I can’t emphasize enough my recommendation to study the Value Investor’s Club because you can obtain
more experience and learn from other’s mistakes.
Classes Oct. 5th & 12th rescheduled for Friday Oct. 7th and 14th from 9 am to 12 pm URIS Room #329 for a make up class. No class Oct. 19th.
I downloaded all the Buffett Letters from Berkshire’s Web-site and then used Google Desktop to search through for any topic.
Assignment:
I left you with the magic formula last week. Next Week Richard Pzena will talk about (Lear Corporation) and read Haugen book—focus on the concepts. Prepare Lear Corp.
An updated chart from last week’s class. Cycles of Value Investing Aug. 2005
Aug. 95 to Feb. 2000: a very tough time for value investors; you remember the Internet phase. Even if you had a great company with excellent prospects, the market didn’t pay for it. S&P 500 up 163% cumulatively vs. up 91% for Value Investors—72% underperformance. If you are running a fund and you beat the value index, the lowest 20% in BV, you would have underperformed by 70% to 60% over five years. If that happens, people leave. Even Richard Pzena, whose firm runs $50 billion dollars, in March 2000, most of his investors had left. His performance since that time has been so phenomenal.
From March of 2000 until today, value has outperformed the S&P 500 by 175% and Pzena did much better than that. People left at the wrong time as usual. If you stick to your guns and your clients don’t you can understand the pressures on a manager? You are looking at a chart through four years and say you will stick it out through the value cycle, but that is an awfully long time and many don’t survive. Some value managers cheated with a value tilt to the S&P, and they got clobbered. They were cheating to hang in there. Even surviving long term with this simple value model is tough.
This may seem like a minor point, but this is the whole story. Really what I am always doing is valuing the
company when I can.
What happens if it is very difficult to value a company? Do something else. That is a very powerful concept if you have the luxury of looking at something else.
The guarantee I made last week is that if your valuation is right, it will usually only take Mr. Market two or three years at most—sometimes a lot faster--to get it right. Do good valuation work.
They way I define value is not low price to book or P/E but intrinsic value. You can see price/book has gotten a little less robust over time from out performing at 6% to 3.1% CAGR.
We are talking about the disparity in performance.
The lesser importance of assets with service businesses as in the past industrial period—perhaps a reason why
book value losing its importance.
I analyze each company from the bottom up. I am very value driven I don’t predict under or out performance of the value cycle.
MAGIC FORMULAS
1. WHAT YOU PAY: “Normalized” EBIT/Enterprise Value (What I pay or pre-tax earnings yield). You would value EBIT higher if tax revenues are lower due to a permanent tax change. Take the after-tax yield and see what the differences are. Is EBIT representative of true cash flow. EBIT is a short hand for EBITDA – Maint. Capex. Different capitalization can skew net income. Differences in tax rates. Using EBIT is a way to compare apples to apples.
2. WHAT YOU EARN: EBIT/(NWC + NFA) the denominator shows what I need to invest in the business to get that EBIT. Don’t forget to normalize investment capital over the course of a year. What I earn.
I told you about my “magic” formula as my starting point for looking at companies.
JG: You bring up a very important point. These are totally two different things.
This is how much I earn based on what I paid for it (EBIT/EV).
This is what I earn based on what the company paid for the assets that created those earnings (EBIT/IC or (NWC + NFA). Those are two totally separate concepts.
Return on the capital they made on the past. So what? Incremental dollars will make good returns but not as high as they made in the past. I may earn 60% ROIC on the new store versus 70% previously in the old store, but there are no other places to earn as high a return so I will still build that store. But if my pretax returns are between 15% and 20%, it doesn’t take too much to tip the balance.
Use normalized EBIT. Look at the normal environment. This is the art part. What I think a normal environment might be. There is nothing special going on in regards to the company or the economy. Obviously it is an assessment now we are into the art part of determining “normalized”.
Here is normalized EBIT over capital invested in the business. This is my best guestimate of what type of business do I have?
When I ran a defense business I had a lot of contact with investment bankers who were pitching acquisitions. They would say, “Well, you can add 20 cents to earnings and make a non-dilutive acquisition by acquiring a business at 9 x EBIT earning 11% pre-tax and that is about flat in growth while borrowing 9.5% partly fixed and partly variable. The spread is 1.5%. Is this worth it for a crappy business? No.
They slapped on the same multiple we had before even though we would be a lot more levered. The
investment bankers had a 400 page report with a nice cover on it, but when you get down to it, this is the bet you are taking. It looks like a bad bet.
Boil the analysis all down to its essence—is it a good business at a good price? Is the bet worth it? Don’t throw out logic. Ask one simple question. How much do I have to pay? How much am I earning? If you have to continually make acquisitions to grow, then it is a different animal.
Company A Company Current Assets 3 3 Fixed Assets 2 7 Goodwill 5 0 Current Liabilities 1 1 Book Value $9 $9
Earnings $2.00 per share in cash
Return on Tangible Capital 50% 22%
You are earning 50% on tangible capital ($2/$4) unless you have to add acquisitions to get future growth. All you have to replace is fixed assets. Your capital spending will be confined to replacing fixed assets. You don’t have to keep replacing Goodwill. Goodwill is a past cost. (See Warren Buffett’s writing in the 1983 Annual Report of Berkshire Hathaway on amortization and intangible assets).
This took me a long time to learn, but if I had read Buffett’s letter in 1983, then I would have learned this sooner.
Forget how the company got there. If the company made bad acquisitions so debt is in the EV. Goodwill is a sunk cost in past acquisitions. If management is a serial acquirer that makes bad acquisitions then the future earnings won’t be what they say it will be. Adjust.
I care about what I have to pay today to generate returns today and in the future. EBIT/EV takes into account for what I paid for it.
If they have land where their factory could be moved and the land used for a higher and better use, don’t just take the value of the land without considering the cost of moving the factory. Do the difference between the industrial land and the value of the land.
Why are we taking Net Fixed Assets (NFA)? It is not always right. Say we buy a hotel for $10 and it is going to last 10 years and we write it down over 5 years and now it is at $5. But if this goes down to zero, I might half to invest another $10. This would give me ($5) a skewed return (being too high) because of not considering replacement and reinvestment into the fixed assets.
Say you have 100 hotels and they are all on different cycles, then on average, you will be correct in using NFA. 10% of your hotels will be refurbished each year over a 10 year normal cycle. That is my quick and dirty for an ongoing business.
Do I have to adjust any numbers based on the unique circumstances of the business. Beware of overstating returns on capital.
Hooke, author of Security Analysis, said that you don’t control the company so you take the capitalization as is so use P/E. It is the hand you drew. JG: I strongly disagree with this—reasonable minds differ—because I have been doing this a long time and EV to EBIT works better than P/E because if management doesn’t optimally use optimal capitalization then someone will come in and do it for you. Using EV/EBIT is the way to go.
Acquisition value is not the same as P/E multiple.
If there are big blips in capex then there will be a hybrid between gross and net. “Roll-ups mean lose money.”
You spent the money on the stores but you don’t receive the EBIT yet, so you must normalize the number for EBIT.
Good Price Good Business
EBIT/EV EBIT/(NWC + NFA)
If you are earning 50% to 60% vs. 15% to 20% then we are looking at two different animals. Then what are their growth prospects, what is there growth rate, bargain price, good business?
20% pretax = 12% after tax. The average for business is 12%.
I don’t make money because I am really smart, I make money because I have a big picture in mind for what I am looking to do. The big picture in mind—is the difference between 50% to 60% vs. 15% to 20%.
Capital Cost: Opportunity cost for my capital
How JG compares investments.
For a $1 of earnings per share after tax what P/E for a non-leveraged company?
Now I have alternatives for my money, the risk-free return is the 10-year bond is less than 6%, I use 6%. Never lower than 6% even if the rates are 4.5%. You know Buffett confirmed that when rates are below 6%, I use 6%.
Now if the 10 year bonds are 7%, then I use 7% as my bogie.
$1 at a 16.66 price earnings ratio is equivalent to 6% yield (risk free rate). If my $1 is going to grow to $1.40 EPs in two years, then I prefer growth vs. a static 6%.
How do you justify 20x or 5% yield on $1? If it is growing and I am confident of that growth. 10% pre-tax = 10% x (1- 40% tax rate) = 6% after-tax.
Compare the opportunities here versus my other choices. I compare a growing 5% yield to a 6% risk-free rate. When I get the money it is after-tax from the company compared to the after tax stream from the bond.
EBIT/EV portion. Then I look at the ROIC portion. Two businesses:
Jason’s Gum Store: $400,000 to build and $200,000 in operating profit so 50% ROIC.
Jimbo’s Just Broccoli: $400,000 earnings $10,000 = 2.5% ROIC. But compared to the 6% government bond yield, Jimbo is actually losing (2.5% - 6%) 3.5% a year. This is crazy unless he thinks the profits will grow tremendously. Though it seems he is making a little bit of money (2.5%), he is actually throwing money away (-3.5%).
This is how I evaluate each business—what are they doing. I won’t pay for a value destroyer. Stay out of Value Traps of just buying low P/E stocks. WEB calls them “cigar butts.”
--I want to look at two things:
Am I getting a good return based on what I am paying and what are the incremental returns (MROIC) on capital? What kind of capital do I have to put in to earn that type of return?
What am I paying and is this a good business? I want to stay out of the value traps. I am really looking at normalized EBIT three or four years out vs. last year’s EBIT.
How much of the money that I earn can I reinvest at the same rate. The incremental return on capital will affect my growth rate. It will affect how much my dollar will grow over time, then it will what normalized growth rates and earnings will be.
Generally, the way I solve any issues like that are…I look for what things in three years will be worth $50 and I pay $25 for them. If it is $45 or $55, I don’t care; I am not smart enough to fine tune it over time. I am picking my spots. There are not that many companies are trading at that discount. It is $38 going to $58 in three years—24% per year. Depending upon how confident I am in that return that may be a great rate of return. Some times I need a higher rate of return depending upon my confidence. I may take a 15% to 20% rate of return despite I like to make more than that. If I am wrong how much can I lose? If I have a lot of room to be wrong and still not lose money. The risk is low.
If the cost of hanging in there is dead money for three years and the $25 goes to $30 or wherever, I get an OK return. Generally, if I am good and I get 4 out of 6 right or how many I get. I look out three years. I take my best shot; I look for a wide disparity. I always looking for a catalyst or the market will realize what I see. What will make people see what I see?
This is a special situations class so I would love to have a catalyst on everything I do. Eventually, in three years or more you don’t even need a catalyst. There are a lot of things that can happen. The efficient market
people are right but only long term. But eventually the facts come out. Whatever people were uncertain
about now over the next two or three years, they find the answer to. There are a lot of people out there trying to figure out what something is worth.
So I think the flaw with the efficient market theory is that it often takes a lot more time. There is often a
lot of emotion in the short term and there is much more uncertainty involved, and people take the discounts for uncertainty but there is more opportunity if you have a longer term horizon. In the short term I don’t think a stock can trade at $20 and $35 and nothing happens and they both can’t be right. The economy doesn’t change that much. In the short term, the market may not be efficient, but in the long term the market
eventually gets it right.
Other times a company may buy back stock if they think it is cheap. These little pieces of paper represent the whole company. Eventually all those things work together to get the right price.
We will talk about Duff & Phelps. I learned from that. Break………
(See case study material on Duff & Phelps before reading this section)
EXERCISE: Duff & Phelps….Buy, hold or sell? Students reviewed the annual report of Duff & Phelps without looking at the subsequent price.
The best section is to look at the front section where they summarized five years of financial and operating history.
This is a great business, it is growing, and it requires low capital intensity. Every dollar they make is spent to buy back shares.
You want to see how the management’s bread buttered. How much of their salary vs. share ownership? If they are giving themselves egregious option packages then I will take that into account.
Income grew but total assets did not grow. Their incremental return on capital is infinite. They can grow without reinvesting their capital.
Did anyone attempt to value this? Duff & Phelps was spun off at $7. EBITDA is 31.25 and EBIT is $28.8.
EBITDA of $31.25 minus capex of $2.5 = $29.535 EV/(Ebitda – capex).
There are negative working capital businesses like MacDonald’s.
Anyone see a problem with using a normalized earnings? Look at the fast growth rate of earnings. Do you think that is sustainable?
I took a normal growth rate over five years.
Three different EBIT growth rates: 8%, 13%, 20%. I chose a conservative 8% growth rate.
EBIT of $43.72 x .6 for taxes = $26.23 x 13 P/E = $341. I shrank the number of shares due to the buy backs down to 3.5 million outstanding shares. I assumed that they were buying back shares with the shares increasing in price by 8% a year. Don’t forget to make assumptions about what they would do with their excess cash.
$341/3.5 = about $95 to $100 per share.
So at $52 today at 8% the stock price was $99; at 13% the price was $122 and at 20% the price was $164. If I go out five years expecting to earn 20% per year, how could I earn the return sooner? Time compressed? How could I make 50% in a year? The market figures it out sooner. I make 76% if pension funds wake up and discount the earnings at 9%.
Duff & Phelps was a small cap stock with low liquidity.
I am always looking at value and where it is now.
This spin off was a good learning tool for (Joel’s interest and work to analyze and invest in) Moody’s. Duff & Phelps was taken over by Fitch at $100.
Compare the multiple to the bond rate. I will take a 5% earnings yield with a great business and with growth vs. 6% bond yield that is flat.
Quality of Earnings Example: Commodore. Work in Process Inventory (WIP) growing faster than Sales. Sunbeam Article in Barron’s. Chain Saw Al stuffed the channels with inventory. Another trick is to write down inventory to 0. 490 million to $0. If there are any sales in future periods then sales will be inflated and there will be extra profits.
$92 million in PP&E removes D&A so earnings are overstated.
Drop in allowance for doubtful accounts is less conservative accounting. Sunbeam still lost money after all these adjustments.
Perelman took stock at $40 but the company was worth $7 per share.
Each mistake leads to better insights and subtleties.
--Greenblatt Class #3
Presentation by Mr. Richard Pzena
Sept. 21, 2006 Three objectives:
(1) I want to talk about value investing in general: why does it works, what are the characteristics that might make you believe there is value, and what makes them (the stocks or the companies) cheap.
(2) How do you actually analyze a business? First generically—what makes a good business? I will spend a little bit of time talking about the difference between a good business vs. a bad business.
(3) Then I will use an example, Lear Corp, as something that might be a value investment. We will try to understand whether it is or is not a value investment.
Feel free to interrupt with questions any time. 1. Let me start with value investing.
I assume you have all read the same things, the academic studies on value investing, They all say basically the same thing that if you do invest and you are sensitive to the price you pay relative to some metric of value like book value, sales, earnings, cash-flow, you tend to naively do well. Fama & French studies show price relative to book value metrics outperforming an index as long as they have a pretty long period to work with. Those studies are repeated over and over again. In fact, I don’t believe you can find a single 20-year period of buying the lowest deciles P/E, P/S or P/Book stocks where you wouldn’t do better than buying an index. There are none. But over the long term it is a strategy that works. I don’t have to use book value, the same thing works with sales, cash flow and earnings--any tangible metric of the size of the business. If you buy a stock at a low price relative to that metric, you outperform the market. Note the large out-performance of the value metrics, however there are periods of underperformance (shaded areas).
Value Invest. Metrics Source: What Works on Wall Street, 3 Editionrd (2005) by James P. O'Shaughnessy
Price/Earnings 1952-59 1960s 1970s 1980s 1990s 2000-2003
ALL Stocks 19.22% 11.09% 8.53% 15.85% 14.75% 5.91%
50 High P/E Stocks 19.27% 10.96% 2.26% 7.99% 16.99% -14.73%
50 Low P/E Stocks 21.84% 13.96% 8.89% 7.56% 13.58% 33.55%
Difference 2.57% 3.00% 6.63% -0.43% -2.85% 48.28% Price/Book Value 50 High P/B Stocks 22.32% 13.13% 0.82% 1.97% 18.03% -31.17% 50 Low P/B Stocks 18.86% 11.49% 17.06% 13.15% 15.83% 25.68% Difference -3.46% -1.64% 16.24% 11.18% -2.20% 56.85% Price/Cash Flow 50 High P/CF Stocks 19.30% 8.02% -3.03% 8.77% 12.77% -27.77% 50 Low P/CF Stocks 18.71% 15.41% 13.57% 12.53% 12.86% 21.23% Difference -0.59% 7.39% 16.60% 3.76% 0.09% 49.00% Price/Sales 50 High P/S Stocks 14.96% 11.99% 5.82% -2.02% -2.46% -42.37% 50 Low P/S Stocks 20.85% 11.15% 14.80% 20.43% 13.80% 19.94% Difference 5.89% -0.84% 8.98% 22.45% 16.26% 62.31%
So why doesn’t everyone just do it, if it is so simple? That is the dilemma for me. Even recently where you
could study this data for decades. In the late nineties, you had the rare ten-year period that showed that value investing didn’t work. We were in a “new world”. Now we are in another “mini-new” world thesis where we will be perpetually short of industrial commodities and energy and those prices will stay high forever. Almost certainly that will end the same way (badly with price declines). You never know when, but this is what happens in the world. People love things; people hate things.
Now, if I were today to look at stocks that were the cheapest on the basis of price to book value, you would probably get a list that not one of you in this room would want to invest in. It would be the airlines, the auto manufacturers, and the insurance companies insured against hurricane losses. It would be a list of companies that you would look at and pass on.
That is why psychotics make better investors (Inside Joke. Joel Greenblatt placed a NY Times article on the board which had the headline, "Psychopaths make better investors.” before introducing Mr. Richard Pzena). Because normal people look at this and read the newspaper and say that is crazy. So value investing continues to work.
What really is the mechanism that is going on that creates the opportunity in value? I want to lay out some data for you that demonstrate what goes on and what lies behind the efficacy of this strategy.
On this axis I will measure time and the other axis will be ROE. If I divide the S&P today into five quintiles based on ROE where the highest ones are in the top left hand corner dropping down in each quintile.
If I could trace out over time what would I see? The companies with the highest profitability decline while the lowest rise--convergence to a mean. You would find that (the mean reversion process) in any market cap, any market in the world, any geographic. Any time period you use, it always looks like this.
I do not think it is very surprising. If you have a company in the left-hand corner up here making lots and lots of money (high ROE), then competitors want to enter that business to make those profits as well. So they try and over time they drive down returns.
Someone has a unique retail concept like Wal-Mart 25 years ago, or you execute it better than everybody else, then as you grow you start with the best locations and then you place new stores into less attractive locations. You don’t know when to stop building Wal-Marts until the ROE begins to decline. There is no formula as to how many to build.
On the opposite side, what do you think these people are doing? They are not jumping off bridges; they are trying to fix things. The low profitability (Low ROE—lower left corner of graph) could be caused by over-capacity in an industry so they take out over-capacity. The cost structure is too high, they change the cost structure; the sales force orientation is not working, so they change the sales force orientation; the product portfolio may not be working, so they change the product portfolio. Everybody not in the upper left quadrant (high ROE) is trying to get there and everyone down in the lower left quadrant (Low ROE) is trying to move up there. Most of them succeed.
Time: Convergence to the
mean
High to
low
ROE
A Growth Investor seeks
to predict the continuation
of a High ROE Company.
A bet against natural
10% to 12 avg. ROE
What is interesting is that this data is not adjusted for survivorship bias. This is including the ones that go out of business. On average companies do not go out of business. On average, poor companies do better and on average great companies that are doing wonderfully, don't do as well. That is why value investing works
because the markets extrapolate the same trends of high ROE companies continuing with the same or higher ROE while low ROE companies have lower to same trends extrapolated into the future. People just don't get it (reversion to the mean) despite many years of evidence.
The people who are buying high growth companies are trying to pick the high growth companies that will not revert to the mean. Some will be great growth or high quality franchise-kind of investors, but you are betting against the odds when you do that. People investing with the low ROE companies with low expectations should be able to outperform the market.
From The New Finance: The Case Against the Efficient Markets, 2nd Edition by Robert A Haugen, "Investors tend to mistakenly project a continuation of abnormal profit levels for long periods into the future. Because of this, successful firms become overvalued. Unsuccessful becomes undervalued. Then as the process of competitive entry and exit drives performance to the mean faster than expected, investors in the formerly expensive stocks become disappointed with reported earnings and investors in the formerly cheap stocks are pleasantly surprised." Page 21.
All you have to do to better than mediocre is to say that you can make some judgment to eliminate the ones, which will go out of business. It is just easier because you don't do anything; just play the odds by buying low P/E or Price to Book. And I will not do any research and over time history shows me that I will win. Then you can try to be more creative by doing better than that, which is what we all spend our time trying to do.
The academic rational is very, very clear for value investing. It is also clear for other types of investing like momentum investing where price trends tend to persist. There is evidence, which suggests businesses doing well, keep doing well. This short-term data contradicts the other long-term data. People who are momentum investors will be sitting on the edge of their chair trying to figure that out when to get out. I think that is hard or harder, but it is valid method backed up by academic data. There is not a whole lot of academic data as you would see going through the Haugen book.
We are doing the opposite by buying companies having problems. There is another book, What Works on Wall Street by Shaughnessy , which is a composite of trying any possible financial statistics and seeing if it worked. Things like buying high growth companies, but it didn't have price in the variable. I would buy a great company, with great management, good growth rate and dominant market position and all of these characteristics that everyone wants in their portfolio. It is the one thing where there is no academic evidence that it works.
The premise we use is of deep value investing because in the end all of these academic studies are using the cheapest quintile or the cheapest deciles of their universe. They are not using what the index is using. If you are familiar with the indexes that institutions use to evaluate money managers, the Russell Value Index and the Russell Growth Index which takes the 1000 largest companies and breaks them into: are they either value or are they growth and puts equal market caps in both. And these consultants conclude that over time that they both do the same, so a smart strategy is to have your portfolio diversified into value and growth. This is the premise of the advice given by lots of consulting firms to institutions. One will work while the other doesn't. Of course, the Russell Value Index is not a value index. It is not a value index in the academic sense. It is just a bunch of stocks that have some characteristics of value, but you are not capturing deep value or the academic version of value. I am trying to distinguish here between a value approach that can buy companies that are low ROE companies and accept that they are not probably going to stay there (move to higher or improving ROE) and ignore the high ROE companies.
When I make a presentation to value investors or when I receive a call from my investors, the single most common question from them is: "Don't you read the papers?" Because if you did then how could you be buying…..didn't you see that their earnings were terrible or they just lost a big account or their customers are bankrupt and on and on and on…..
That is why these things are cheap. They are cheap for a reason. The point that I am making is that you never, never find things that are cheap for no reason. I hope to find one some day but it doesn't happen. You have to accept that you don't get the best businesses with great management teams with high margins, with great growth rates and high market share selling at low prices. You don't get those. But good businesses can sell for low prices generally when one or more of those things listed above are missing. When there is some blood on the table.
A basis for contrarian investing: There is some evidence that suggests that markets do overreact to both good and bad news, especially in the long term, and that stocks that have done exceptionally well or badly in a period tend to reverse course in the following period, but only if the period is defined in terms of years rather then weeks or months (Source DeBondt & Thaler).
2. Businesses in General
Let us talk about businesses in general.
Student: What time horizon are you speaking about regarding the ROE change and decline
for high ROE Companies?
Richard Pzena (RP): About five years. On average their economics deteriorate while the low ROE
companies improve.
If you can combine a company that has a low valuation and should have a sustainable edge, but may, in the present, may not be experiencing it for some--and it may be temporary--reason, then you have this
unbelievably powerful combination. If you can buy a good business at a low price, then you have nirvana. Characteristics of good businesses
• High Barriers to Entry
• High Margins
• Good management
• Pricing Power
Low capital intensity--RP: but doesn’t a company with low cap intensity have low barriers to entry? (Sees Candy is a counter example). I think capital is a barrier. Would you pursue competing against Boeing with enough capital and find a good person to do that? Is there a barrier to entry? Clearly if no capital is required then there is easier entry.
Why is it that Boeing over time produces good profit margins but Sprint or Verizon Wireless doesn't--they are both equally capital intensive? Answer: High switching costs. Concentration of the marketplace--wouldn't you say an industry with two players vs. eight players has a higher chance for rational behavior? (Boeing and Airbus make up the two major air plane manufacturers in the world, so the structure of the market is an oligopoly with more rational pricing and high barriers to entry).
Will jetBlue sustain its high profit margins? Would you want to bet that? Does jetBlue have a sustainable competitive advantage for the long term? What is that? Better quality of service. How do you account for the fact that the (Airline) industry has been unbelievably unprofitable its entire life? Last cycle SouthWest Airlines (SWA) was the JetBlue. Now SWA is history. How does JetBlue all of a sudden appear? And if JetBlue can appear all of a sudden, why would you be confident that another JetBlue doesn't all of a sudden appear? (The Airline Industry has easy entry with no incumbent competitive advantages).
JetBlue has a no barriers to entry model. There may someday be barriers to entry unless there is a slot restricted type of markets. JetBlue could go to an airplane leasing company so capital was not a barrier. An airplane holds its value. If lease financing was not available and airplane values were highly erratic, then you might have a different outcome.
If one guy is standing out better than everyone else, I would be nervous. jetBlue probably has a good business model given the industry. Clearly, the history suggests the industry is a bad business.
What are some barriers to entry?
• High switching costs
• High capital costs
• Brands
• Lower operating costs (airline with 1 low cost fleet, by operating in a certain way, locks you in)
• Tobacco with its addicted customers
Value investing works because it doesn't always work. Just naively using value metrics would allow you to
outperform the benchmarks. Barriers to Entry
• Patented technology
• Government regulations No advertising in chewing tobacco, so SKOL has an advantage
• Brands
• Customer captivity and Economies of Scale: An Airline with same models allows it to operate cheaper than competitors, which causes customer lock-in.
So we have a general view of what makes a good company….I think the important point comes in many forms. It could be simple like physical location where you have a ten-year concession to sell trinkets at the Statue of Liberty. You could have natural resources (low cost copper mine), low transport costs (A Rock Quarry) so physical assets and location could be one form of barrier to entry.
Another could be some form of competitive cost advantage like a mining company—a copper deposit that costs 10 cents to extract while everyone else is at 50 cents a pound, I would say that business is nicely protected. It could be a patent or a technology—you have something that no one else has or will have. Coca-Cola has a franchise—nobody spoke about franchises-- where it has been built over decades which give Coke a competitive advantage of high barriers to entry. Coke is associated with good things; it has mind share.
I would define a good business where you can identify specifically a reason why it should be able to earn an excess return on its cost of capital. It has to be a simple reason that you can clearly see.
The Auto Industry is the exact opposite where it is actually easy to see why it wouldn’t earn the cost of capital. It is a commodity business, because it is a high fixed cost business where capacity is relatively fixed and the product has a cyclical sales cycle, so people kill each other because they can’t produce above their fixed costs. You normally see it with their historical return on capital or ROE over time. Look at the last 10 or 20 years of the company and say, “Is it (ROIC) high? Is the ROE high? If you do this analysis, any company that has been able to earn in excess of 10% to 12% on total capital employed after tax over time, you have to say to yourself, “OK, this looks like a good business.
Now can I identify why it is a good business? I would say JetBlue is earning above its cost of capital and therefore is a good business, but do I understand why? Yeah, I get it. I think it is sustainable, then you have a good business.
If I can combine a cheap price with a good business, that is what I am trying to do.
One, I want to talk about: Is it a good business? Then go through the characteristics of the company and ask if it is a good business or not?
Student: High ROIC, High ROE and you see it is sustainable—it looks like a good business. How do you
ascribe this to your earlier point of regression to the mean?
RP: Typically, good businesses where you are seeing that on a consistent basis, you rarely see them cheap,
they are not good stocks to invest in. What creates value?
What creates value? We talked about how value gets resolved—the bad stops being bad and things don’t stay good forever. How does value get created? Value gets created for almost the same reason, because something went wrong and because there is deterioration. Something went wrong.
The pattern is almost always the same. If you have a company that is chugging along just fine and something falls off trend--that is what creates value. The stock price, especially if the price is looking far out into the future for a continuation of earnings growth, the price will fall dramatically if the earnings fall off their trend. The dilemma that every value investor faces: the academic studies also show that buying a stock in a business that is deteriorating is a bad idea because there is serial correlation in goodness and in badness—which is counter to the ROE example and argument. Both of those phenomena are happening. In the short term there
is serial correlation and in the long run there is competitive pressure. They both have an impact. It is
deterioration that creates value.
So if you buy a stock that is deteriorating, you are an idiot. The problem is that if you wait for the earnings to turn or the catalysts or the revisions from Wall Street, then you will be too late and not get a cheap price.
Student: Would you have a preference for a good business or a low price?
RP: I would invest in only a cheap stock, but I would give credit for a good business to the extent that that
good business justifies better earnings power. For me the issue is price relative to the companies normalized earnings power. So if I had to pay up for KO just to feel better because KO has a stable earnings base, I wouldn’t do it. But if it translates into higher earnings than some other investment and I could quantify that my price is low relative to some future earnings power, then I will (invest). I have never found KO to be cheap.
What you find is the business deteriorates and management tries to do something and then the business stabilizes at a lower level. This is where I try to buy—in the trough of stabilization of the business. Most people are unwilling to buy it here because most people don’t know if it is going to go back up here.
You can speculate because it is a good business because of this, this and this but it isn't going up right now. But I am going to buy it because I know if it does go up, I am going to make a lot of money and if it doesn't, I won't lose a lot of money. There is a better risk/reward trade-off.
Value is created by deterioration. The price drop relates to the deterioration while the value captured is associated with price reverting back to trend or the mean. You have to accept further price declines when you
Price
Richard Pzena tries to buy in
here.
Richard Pzena does not try
to buy in here, after good
news.
buy while the business continues deteriorating, and if you wait, you will pay up while recovering and miss a good opportunity. Once you can see a catalyst, you are late and you are playing partial momentum here.
SUMMARY
You have better odds in the value camp, because you are playing in a better field. So if I was mediocre, I would beat the market.
But to be great one must distinguish--what this tells you (lowest quintile) is that those companies are
experiencing problems; some are experiencing temporary problems. The way you can add value is to
distinguish between temporary and permanent problems. Getting a good business at a good price is
nirvana. A low price will be associated with problems surrounding the company and its business.
3. LEAR CORPORATION
What does Lear Corporation (LEA – NYSE) do? They are a supplier of parts to the auto manufacturers. They make seats.
Is this a good business? It doesn't look like a good business? Why? They make a commodity—seats and auto parts?
Bad Characteristics of LEAR Good Characteristics of LEAR
(LT) Squeezed by concentrated customers (LT) Established quality reputation-concentrated customers (ST) SUV Reliance (two years ago in the + column) (LT) Ideal Outsourcer--this is why they grow
(ST) Cyclical Peak Asian Growth
(ST) European Slowness Rational capacity
(LT) High Debt--it can be a permanent issue. (ST) Rising raw materials
Characteristics of long-term vs. current environment.
Too much capacity is a bad thing, but rationalization of capacity is a good thing.
Let us go back and review which of these characteristics are characteristics of the company and the markets in which they compete in long term and which of these are typical of the current market.
When I am asking about what makes a good business vs. what makes a bad business, I am not talking about current conditions.
Toyota outsource seat supplies so why couldn't Lear supply in the future?
Europe is 65% outsourced while the US is 90% outsourced. Lear has a flexible, low cost model. Though Lear has a union work force, they can lay off workers and close down plants.
The auto manufacturer (Ford or GM) puts investment into a model, which will either do well or not. The cyclicality will average out over time. Lear is in a different fixed cost position than the auto manufacturer. You can say that is bad because of their concentrated customer base.
Questions:
Value Investor:
Invest in fifth quintile: Low price/Book or P/E
Add Value:
Is this a good business (high ROITC)? Low value due to permanent or temporary problem? Determine the difference.
